SAIC: So Am I Crazy?

Motley Fool Inside Value recommendation SAIC (NYSE: SAI  ) bills itself as "a leading provider of research, engineering, and technology services and solutions." On Tuesday, it "provided" us with something else -- an earnings beat. Yet despite turning in Q4 earnings of $0.25 per share (up 25% year over year, and better than the $0.22 predicted), the stock took a 2% dive yesterday. Why? Why, let's find out why.

There's no "Y" in G-O-O-D N-E-W-S
At first glance, the SAIC Q4 report was nothing short of brilliant. Let me list a few of the highlights for you. Since this was also the annual report, I'll focus on the full-year 2007 numbers:

  • Revenues increased 11% to $8.94 billion. Seven percentage points of that growth were organic -- what SAIC refers to as "internal" growth. The rest came from acquisitions.
  • That said, operating income, which backs out earnings from interest, outpaced sales growth, rising 16% year over year to the sum of $666 million.

Big picture view
Now, you may be aware that SAIC has some long-term goals in mind for how to grow its business. Management targets organic sales growth of 6% to 9% per year, with additional growth from acquisitions. SAIC also aims to improve the profits extracted from its growing revenue streams, adding 20 to 30 basis points per year, until it finally tops out at about 8% or 9% operating margins. All of this is supposed to add up to earnings per share (EPS) growth of 11% to 18% per year from continuing operations, on average.

For a defense contractor, these seem both modest and achievable goals. Defense-oriented contractors like General Dynamics (NYSE: GD  ) , Lockheed Martin (NYSE: LMT  ) , and Raytheon (NYSE: RTN  ) routinely do low-double-digit operating margins. Contractors with a more civilian bent, such as Accenture (NYSE: ACN  ) , IBM (NYSE: IBM  ) , and Infosys (Nasdaq: INFY  ) , are able to do even better -- pulling down margins well into the mid-teens, and even the 20s (for the Indian superstar.) To me, that makes SAIC's long-term profitability goal look eminently attainable.

What's more, management proves it's on the right track. You'll notice that its organic sales growth last year was right in line with long-term goals. Margin improvement was even a bit ahead of schedule, as operating margins grew 40 basis points to 7.5% for the year. So, to me, the fact that SAIC failed to meet its own goal of double-digit EPS growth only because it had less cash in its savings passbook is a nonissue. Long term, this company is on track.

With a few caveats
So that's the good news, but I don't want this column to be all sweetness in light. Mr. Market may be moody, but there was at least some method to his madness in selling off SAIC yesterday. Here's the dark lining around this year's silver cloud: SAIC blamed a three-day increase in days sales outstanding (which slows the inflow of cash) and "increased working capital needs to support revenue growth acceleration" (which accelerates the outflow) for a massive decline in operating cash flow for the year.

Massive?
Yes, massive. I don't use the word lightly. Free cash flow at SAIC plummeted 54% from last year's levels, down to $284 million. And here's why that bothers me -- SAIC already looks like a pretty expensive stock. It sells for a 19 trailing P/E yet, by management's own admission, is unlikely to post more than 18% annual profits growth at best. More likely, in the estimation of Wall Street analysts, it's gonna be sub-14% annual profits growth over the next five years.

Even if I look past the evident overvaluation that the resulting 1.4 PEG ratio suggests, there's now the additional worry that SAIC generated significantly less free cash flow than it reported as GAAP earnings last year ($284 million FCF vs. $415 million net income.) This jacks SAIC's price-to-free cash flow ratio up to nearly 27, or almost twice the analysts' estimated percentage growth rate over the next half decade.

So you tell me: Am I crazy, or is all of SAIC's good news -- and more -- already priced into this stock?


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